It has already been stated that the cost of capital is one of the most crucial factors in most financial management decisions. However, the determination of the cost of capital of a firm is not an easy task. The finance manager is confronted with a large number of problems, both conceptual and practical, while determining the cost of capital of a firm. These problems can briefly be summarized as follows:
1. Controversy regarding the dependence of cost of capital upon the method and level of financing
There is a, major controversy whether or not the cost of capital dependent upon the method and level of financing by the company. According to the traditional theorists, the cost of capital of a firm depends upon the method and level of financing. In other words, according to them, a firm can change its overall cost of capital by changing its debt-equity mix. On the other hand, the modern theorists such as Modigliani and Miller argue that the firm’s total cost of capital is independent of the method and level of financing. In other words, the change in the debt-equity ratio does not affect the total cost of capital. An important assumption underlying MM approach is that there is perfect capital market. Since perfect capital market does not exist in practice, hence the approach is not of much practical utility.
2. Computation of cost of equity
The determination of the cost of equity capital is another problem. In theory, the cost of equity capital may be defined as the minimum rate of return that accompany must earn on that portion of its capital employed, which is financed by equity capital so that the market price of the shares of the company remains unchanged. In other words, it is the rate of return which the equity shareholders expect from the shares of the company which will maintain the present market price of the equity shares of the company. This means that determination of the cost of equity capital will require quantification of the expectations of the equity shareholders. This is a difficult task because the equity shareholders value the equity shares on the basis of a large number of factors, financial as well as psychological. Different authorities have tried in different ways to quantify the expectations of the equity shareholders. Their methods and calculations differ.
3. Computation of cost of retained earnings and depreciation funds
The cost of capital raised through these sources will depend upon the approach adopted for computing the cost of equity capital. Since there are different views, therefore, a finance manager has to face difficult task in subscribing and selecting an appropriate approach.
4. Future costs versus historical costs
It is argued that for decision-making purposes, the historical cost is not relevant. The future costs should be considered. It, therefore, creates another problem whether to consider marginal cost of capital, i.e., cost of additional funds or the average cost of capital, i.e., the cost of total funds.
5. Problem of weights
The assignment of weights to each type of funds is a complex issue. The finance manager has to make a choice between the risk value of each source of funds and the market value of each source of funds. The results would be different in each case. It is clear from the above discussion that it is difficult to calculate the cost of capital with precision. It can never be a single given figure. At the most it can be estimated with a reasonable range of accuracy. Since the cost of capital is an important factor affecting managerial decisions, it is imperative for the finance manager to identify the range within which his cost of capital lies.
Credit: Financial Management-MGU MBA